Price adjustments under fixed exchange rate, Microeconomics

Assignment Help:

PRICE ADJUSTMENTS UNDER FIXED EXCHANGE RATE:

In a flexible exchange rate regime trade deficits (surpluses) are automatically corrected by a depreciation (appreciation) of a country's currency. On the other hand, in a fixed exchange rate regime, disequilibrium conditions are corrected by changes in domestic prices. A deficit reduces the country's money supply which in turn reduces the prices. The reduction in the country's money supply will tend to increase the interest rate, which in turn dampens the investment and thereby reduces aggregate demand. Consequently, price level will fall which will encourage exports and discourage imports.

At the same time, higher interest rate induces capital inflows that would help in financing the deficit. he process of price adjustment under the fixed exchange rate regime is similar to that of the price adjustment under the gold standard, i.e., price-specie-flow- mechanism. Under gold standard, a country's currency is defined by the gold content. This is to say that a country will be ready to buy or sell any amount of gold at that price. Further, as the gold content in one unit of currency is fixed, exchange rates will also be fixed. For example, assume that a £1 gold coin in the UK contains 113.0016 grains of pure gold, while a $1 gold coin in the US contains 23.22 grains of gold. This implies that the exchange rate ($/£) is 4.87 (i.e., 113.0016 ÷ 23.22). Assuming no shipping costs,
exchange rate will be stable unless there is a change in the gold reserves of any country. 

This is because no one will be willing to pay more than $4.87 for a £1 coin as gold worth of $4.87 can be purchased in the US and exchange it for £1 in the UK. Similarly gold worth £1 can be purchased in the UK and exchanged for $4.87 in the US. These gold outflows/inflows measure the size of Balance of Payment deficit/surplus. 

In a deficit situation, the automatic adjustment mechanism is as follows: With gold outflows under trade deficit, country's money supply will fall, which in turn, triggers a fall in internal prices. As a result, exports will be encouraged and imports will be discouraged until the deficit in BoP is eliminated. 

This adjustment mechanism operates in a similar manner even if a country is not following a gold standard. The foreign exchange reserves held by a country is akin to the gold reserves. As such, disequilibrium in trade flows will be reflected in the changes in the foreign exchange reserves which in turn influences the money supply and thereby the domestic prices.


Related Discussions:- Price adjustments under fixed exchange rate

Concept of stock replenishment, Concept of Stock Replenishment  This c...

Concept of Stock Replenishment  This concept assumes that stock is always available whether there is demand or not. Consider the demand for constituent items, such as componen

What is Isomers and Types of Isomers, Isomers are two or more forms of comp...

Isomers are two or more forms of compounds which having the same compositions. Types of isomers (a) Stereo isomers (b) Structural isomers

Economics of exhaustible resources, Normal 0 false false fa...

Normal 0 false false false EN-IN X-NONE X-NONE MicrosoftInternetExplorer4

Market structures, illustrate and discuss the implications of various marke...

illustrate and discuss the implications of various markets structures(competitive and non-competitive) for price dertimation

What is economic theory, What is Economic Theory? An economic theory th...

What is Economic Theory? An economic theory that can be considered an axiomatic approach comprise a set of assumptions and circumstances, an analytical framework and explanatio

Measuring economies of scale in long run, Economies and Diseconomies of Sca...

Economies and Diseconomies of Scale -Economies of Scale Increase in the output is greater than increase in the inputs. -Diseconomies of Scale Increase in the

Whata are the non-renewable resource, How does the approach of someone who ...

How does the approach of someone who has adopted the precautionary principle differ from someone with a blind faith in substitutability, when it comes to a non-renewable resource l

Explain the long run incremental cost, Question: (a) Long Run Incremen...

Question: (a) Long Run Incremental Cost (LRIC) is considered as the "gold standard" for setting interconnection charges. Discuss the strengths and weaknesses of the three ap

Labour Economics, Sally recently finished her full time training and receiv...

Sally recently finished her full time training and received certification as a nurses aid at the end of august.

General equilibirium, What is the theory of second best? Prove the theorem ...

What is the theory of second best? Prove the theorem with the help of a diagram

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd